U.S. shale companies hedges were inadequate for oil price crash

Devika Krishna Kumar and Liz Hampton

NEW YORK/DENVER, March 13 (Reuters) - Oil prices have plunged so much that even U.S. shale producers who have paid for the industry's version of income insurance must deal with big holes in their budgets. Crude oil prices have crashed about 50% this year, hit by the coronavirus outbreak and the surprise price war that erupted last weekend between Saudi Arabia and Russia. The U.S. crude benchmark on Thursday closed at $31.50 a barrel, far below the $50-per-barrel price where many companies hedged. With prices at three-year lows, shale producers also are exposed because they used options in such a way that their insurance erodes the more oil declines. "U.S. production is likely less well hedged than the market realizes," said Michael Tran, managing director of energy strategy at RBC Capital Markets in New York. Shale companies protect their revenues with hedges because oil prices can swing wildly due to unforeseen events. About 43% of 2020's oil production was hedged as of the end of the fourth quarter, according to Goldman Sachs. But that 43 percent is not fully covered. Producers use a variety of methods to hedge production. The simplest is to purchase a put option that allows the holder to sell at a fixed price at a particular time, regardless of where oil prices are trading. That locks in a selling price of, say, $50 a barrel. Many shale producers used a more complex strategy, known as three-way collars. Producers still buy the put options as insurance, but they also sell other put options, often with a lower price point - to lower or eliminate the cost of their insurance. Effectively, this is a calculated bet that oil will fall to a certain level and no further. But that was not what happened. "Using many of these structures, producers are price-protected unless prices fall below a certain threshold, and $45 a barrel was a popular strike level, at which point producers become fully exposed," Tran said. RBC Capital Markets equity analysts said Marathon Oil hedged about 38% and Pioneer Natural Resources 54% of estimated 2020 production, using three way collars. Marathon and Pioneer did not respond to requests for comment. Marathon was one of numerous companies this week that announced drastic spending cuts. Futures and options-market volumes hit a record on Monday, CME Group said. Some shale companies are looking to unwind hedges, selling the financial contracts to generate cash, market sources said, adding that others are looking to restructure their hedge positions to secure protection at lower price levels. "Our E&P clients are now all re-evaluating the hedges they have," Steve Sinos, vice president of Mercatus Energy Advisors, using the acronym for exploration and production. Occidental Petroleum constructed a complicated hedge that protected their selling price for 2020 down to $45 per barrel Brent while leaving them fully exposed to downside in 2021, according to company filings. That company cut its dividend by 86% this week and said it would slash spending. Parsley Energy restructured hedges earlier this month in expectations of falling prices, but those changes were modest, and were done before this week's rout. "The whole industry is not evenly hedged," said Trisha Curtis, co-founder of Denver-based consultancy PetroNerds. She said hedged operators may still need to cut back on rigs and hydraulic fracturing fleets that produce oil and gas from shale rock.

UNHEDGED Some firms were not hedged at all, including Apache

and Continental Resources , according to the latest

annual filings. "Apache's approach in response to oil price dislocations has been to quickly adjust our activity and spending as appropriate, and that is what we are doing now," said Gary Clark, vice president of investor relations at Apache, in a statement. Continental did not respond to a request for comment. Shale firms are only now starting to hedge for 2021. Goldman Sachs said just 2% of production for 2021 has been hedged, and now companies face the likelihood that they will not be able to lock in prices that will guarantee profits given their costs. Most shale companies need prices above $40 per barrel to break even on costs at the well, but the market has been well above that level for most of the last couple of years.

(Reporting by Devika Krishna Kumar in New York and Liz Hampton in Denver; Editing by David Gregorio)

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